THE DODD-FRANK financial overhaul law required the Obama administration to produce a plan by no later than Jan. 31 for reforming the nation's mortgage finance system, which is dominated by the crippled government-sponsored enterprises (GSEs) known as Fannie Mae and Freddie Mac. Fannie and Freddie, currently operating under direct federal control, back about 90 percent of all new U.S. mortgages, but their taxpayer-covered losses have hit $150 billion - and are rising. Their combined debt, guaranteed by taxpayers and held in large part by China and Japan, is more than $1.5 trillion. But the administration still hasn't come out with anything, though we're told it's forthcoming.

Meanwhile, let us take a shot. The first question is why the United States might need a government role in securitizing mortgages in the first place. For many years, during the long reign of Fannie and Freddie, the answer was: to promote homeownership by keeping home mortgage finance cheap and available, even during the economy's cyclical downturns. Only a government backstop, the argument goes, can compensate lenders for the risk of lending to homeowners at a fixed rate for 30 years in a world where rates fluctuate. Homeownership does help instill thrifty habits and solidify communities, but it can be taken too far. And, in recent decades, it was. Along with other policies such as the home mortgage interest deduction and credit allocation goals for borrowers with low incomes, the GSEs helped fuel unsustainable over-investment in housing.

How unsustainable? The national homeownership rate today has slipped back to its 1998 level, according to the Census Bureau. In terms of building community, etc., it's as if the past 13 years never happened, except for the catastrophic losses to taxpayers - and home buyers. It might be more accurate to say that federal housing policy has helped destroy communities.

Does this prove that all government intervention is bound to fail or merely that the Fannie-Freddie model was flawed? The GSEs were government-chartered, which gave them access to cheap capital based on the assumption by investors that they would be bailed out in a crisis; yet they were also privately owned, which drove them to maximize profits. In short, they had both the incentive and the capacity to take on excessive risk. One proposal for reforming, but not ending, government-backed securitization would abolish the GSEs and replace them with private firms that would package and sell mortgage-backed securities with an explicit government guarantee. The firms would pay the federal government for the guarantee; those fees, in turn, would fill a crisis bailout fund that distressed entities could draw on if their own reserves ran out. The institutions would serve only "prime" borrowers - those with high credit scores and plenty of equity.

This concept, various iterations of which are circulating on Capitol Hill, the think tanks and K Street, is an improvement over Fannie and Freddie in that it replaces a murky public-private nexus with transparent rules. But there's a problem, as the GSEs' current top regulator, Edward J. DeMarco, told Congress in September: "First, the presumption behind the need for an explicit federal guarantee is that the market either cannot evaluate and price the tail risk of mortgage default . . . or cannot manage that amount of mortgage credit risk on its own. But we might ask whether there is reason to believe that the government will do better? If the government backstop is underpriced, taxpayers eventually may foot the bill again." Indeed, the experience of Fannie and Freddie, which organized a fearsome lobby to protect and expand their business, suggests that the new government-backed system will quickly come under interest-group pressure to reduce the guarantee fee, steer liquidity to "underserved" groups and otherwise loosen taxpayer protections - all in the name of "the American dream."

More fundamentally, this alternative does not address the question of why government should insulate housing, alone among all market sectors, from the vagaries of the business cycle. True, partly as a consequence of federal policy, home equity represents the bulk of household wealth in America; removing government backing entirely might erode it even further. Yet other countries have high rates of homeownership without government-backed mortgage securitization. If government doesn't steer capital into housing, the capital doesn't disappear; it could fund other job-creating businesses.

Congress and the administration should not settle for a second-best solution. To be sure, immediately ending Fannie and Freddie would be impractical, given the fragile market's dependence on them. But they can and should be shrunken and broken up gradually over several years, with their bad assets liquidated by the government and their good ones sold at a profit to the private sector. Thereafter, financial institutions would be free to hold loans in their portfolios or to securitize whatever loans investors want to buy - subject to the discipline of the marketplace and tight federal regulation of mortgage underwriting. Government aid to low-income home buyers would be limited to the Federal Housing Administration, whose activities are on-budget and transparent.

There are risks in this approach, of course: Big banks that entered the securitization business would get bigger, perhaps "too big to fail." But we prefer the potential risks of privatization to the proven risks of government-backed mortgage securitization. Indeed, no one is suggesting a pure "free market" approach. There should still be not only tough underwriting rules but also requirements that loan securitizers maintain adequate capital and retain some of the mortgages they securitize on their own books.

Advertised as a way to stabilize the housing market, government-backed mortgage securitization ended up distorting and destabilizing it. The resulting misallocation of resources - evident not only in today's massive bailout of Fannie and Freddie but also in the vast quantities of land, water and energy wasted on suburban sprawl from Las Vegas to Fort Lauderdale - is a true American tragedy. Today's housing crisis is an opportunity to make sure nothing like it ever happens again.